Apparently “playing by the rules” , according to Obama, includes taking an adjustable mortgage that results in monthly payments equal to 43% (or more) of income. According to the Homeowner Affordability and Stability Plan

“For a sample household with payments adding up to 43 percent of his monthly income, the lender would first be responsible for bringing down interest rates so that the borrower’s monthly mortgage payment is no more than 38% of his or her income. Next the initiative would match further reductions in interest payments dollar-for-dollar with the lender to bring that ratio down to 31 percent…”

So in the case of two families with identical earnings and living in identical houses we take the tax money of the responsible family that saved for a downpayment and give it to the irresponsible family that didn’t. And if you were responsible enough to rent until prices came down then you’re just out of luck.

Redistributing wealth based on income is a crude, but necessary, manner of levelling an uneven playing field. Redistribution based on debt introduces considerably more unfairness.

Many people have pointed out that stocks all become perfectly correlated in times of crisis. That’s not strictly true but correlations do increase dramatically. Over the past six months (August 4th, 2008 to January 30th, 2009) notice how correlations (for a portfolio containing a selection of the Dow components) have averaged 0.67 and volatility across the portfolio has been 3.1% for the daily return standard deviation.

BAC

GE

IBM

INTC

JNJ

KO

MCD

MMM

MRK

MSFT

PFE

PG

T

WMT

Return

StdDev

Bk Of America Cp

BAC

-95.8%

9.8%

Gen Electric Co

GE

0.63

-80.9%

4.8%

Intl Business Mac

IBM

0.66

0.68

-48.1%

3.0%

Intel Corporation

INTC

0.57

0.64

0.74

-66.9%

4.1%

Johnson And Johns

JNJ

0.50

0.58

0.67

0.69

-28.4%

2.5%

Coca Cola Co The

KO

0.39

0.45

0.56

0.66

0.72

-35.8%

2.8%

Mcdonalds Cp

MCD

0.54

0.62

0.66

0.66

0.69

0.66

-5.5%

2.7%

3 M Company

MMM

0.56

0.66

0.68

0.68

0.77

0.66

0.75

-39.3%

3.0%

Merck Co Inc

MRK

0.55

0.62

0.71

0.75

0.80

0.66

0.73

0.72

-23.6%

3.5%

Microsoft Corpora

MSFT

0.58

0.55

0.75

0.80

0.72

0.68

0.68

0.68

0.73

-54.0%

4.0%

Pfizer Inc

PFE

0.61

0.60

0.66

0.70

0.76

0.64

0.67

0.71

0.80

0.70

-37.5%

3.2%

Procter Gamble

PG

0.53

0.62

0.68

0.69

0.84

0.70

0.73

0.78

0.82

0.72

0.77

-30.1%

2.6%

At&T Inc.

T

0.60

0.57

0.72

0.72

0.77

0.64

0.69

0.69

0.79

0.75

0.75

0.76

-29.7%

3.6%

Wal Mart Stores

WMT

0.44

0.51

0.57

0.57

0.75

0.61

0.72

0.66

0.71

0.61

0.64

0.73

0.66

-34.4%

2.7%

Exxon Mobil Cp

XOM

0.49

0.56

0.71

0.72

0.81

0.64

0.71

0.72

0.78

0.76

0.76

0.78

0.81

0.67

1.9%

4.3%

Portfolio

-44.6%

3.1%

Historically, the same portfolio has exhibited correlations between the various components which have been considerably lower. In fact, over the past twenty years (February 2nd, 1989 to Jan 30th, 2009), correlations have averaged 0.32, approximately half the correlation we have seen recently. The standard deviation of the daily returns was only 1.1%

H1-B visa holders are the Palestinians of American politics (with apologies to the Palestians). Each side uses them for their own interests. One side wants to protect them from being exploited and the other side wants to prevent them from exploiting. Neither side has their best interests at heart.

U.S. Senator Charles Grassley, an Iowa Republican, sent this letter to Microsoft [emphasis mine].

January 22, 2009

Mr. Steve Ballmer

Microsoft Corporation

One Microsoft Way

Redmond , WA 98052-6399

Dear Mr. Ballmer:

I am writing to inquire about press reports that Microsoft will be cutting approximately 5,000 jobs over the next 18 months. I understand that the layoffs will affect workers in research and development, marketing, sales, finance, legal and corporate affairs, human resources, and information technology.

I am concerned that Microsoft will be retaining foreign guest workers rather than similarly qualified American employees when it implements its layoff plan. As you know, I want to make sure employers recruit qualified American workers first before hiring foreign guest workers. For example, I cosponsored legislation to overhaul the H-1B and L-1 visa programs to give priority to American workers and to crack down on unscrupulous employers who deprive qualified Americans of high-skilled jobs. Fraud and abuse is rampant in these programs, and we need more transparency to protect the integrity of our immigration system. I also support legislation that would strengthen educational opportunities for American students and workers so that Americans can compete successfully in this global economy.

Last year, Microsoft was here on Capitol Hill advocating for more H-1B visas. The purpose of the H-1B visa program is to assist companies in their employment needs where there is not a sufficient American workforce to meet their technology expertise requirements. However, H-1B and other work visa programs were never intended to replace qualified American workers. Certainly, these work visa programs were never intended to allow a company to retain foreign guest workers rather than similarly qualified American workers, when that company cuts jobs during an economic downturn.

It is imperative that in implementing its layoff plan, Microsoft ensures that American workers have priority in keeping their jobs over foreign workers on visa programs. To that effect, I would like you to respond to the following questions:

* What is the breakdown in the jobs that are being eliminated? What kind of jobs are they? How many employees in each area will be cut?

* Are any of these jobs being cut held by H-1B or other work visa program employees? If so, how many?

* How many of the jobs being eliminated are filled by Americans? Of those positions, is Microsoft retaining similar ones filled by foreign guest workers? If so, how many?

* How many H-1B or other work visa program workers will Microsoft be retaining when the planned layoff is completed?

My point is that during a layoff, companies should not be retaining H-1B or other work visa program employees over qualified American workers. Our immigration policy is not intended to harm the American workforce. I encourage Microsoft to ensure that Americans are given priority in job retention.Microsoft has a moral obligation to protect these American workers by putting them first during these difficult economic times.

Sincerely,

Charles E. Grassley

United States Senator

Of course, no mention of Microsoft’s moral obligation to its shareholders. And I don’t remember anyone caring about “the American workers” when we tied Microsoft up in court for years and drained their coffers. Maybe those laid off can dust themselves off and volunteer at Mozilla, the organization “dedicated not to making money”.

If US immigration policy is not intended to harm Americans then who is it intended to harm?

What has been wanting on the right at the start of this century is a true “conservative disposition” — the disposition to enjoy what is rather than pining for what might be (to paraphrase Himmelfarb), to enjoy the givens and the goods of life without subjecting them to social or political validation.

His [the Rationalist’s] mental attitude is at once sceptical and optimistic: sceptical, because there is no opinion, no habit, no belief, nothing so firmly rooted or so widely held that he hesitates to question it and to judge it by what he calls his ‘reason’; optimistic, because the Rationalist never doubts the power of his ‘reason (when properly applied) to determine the worth of a thing, the truth of an opinion or the propriety of an action. Moreover, he is fortified by a belief in a reason’ common to all mankind, a common power of rational consideration, which is the ground and inspiration of argument: set up on his door is the precept of Parmenides–judge by rational argument. But besides this, which gives the Rationalist a touch of intellectual equalitarianism, he is something also of an individualist, finding it difficult to believe that anyone who can think honestly and clearly will think differently from himself.

Volatility is usually expressed as the annualized standard deviation of returns. Volatility is proportional to the square root of time. That means one can approximate a volatility over a smaller time period than one year by dividing the annual vol by the square root of the number of trading periods one is interested in.

So, to convert annual volatility to a daily vol, divide by 16, which is the square root of 256 — about the number of trading days in the year.

Back in the days when vol was 15-20% annually (way back in 2007), a daily vol was about 1%. These days, the VIX is closer to 80 which implies a daily return of +- 5%.

On Sept 15th, 2008, when Lehman was allowed to go bankrupt (“Lehman is not too big to fail” – Paulson), the VIX went up to 80 and has been in that region ever since. The Lehman bankruptcy has turned out to be a massive event in financial history.

Others have weighed in on whether volatility should be considered an asset class. From the point of view of a long term investor it clearly doesn’t make sense to buy and hold volatility. (In that sense, it is the ultimate cyclical asset class and we should be glad we don’t live in a world of ever increasing volatility!). However, in terms of the diversification benefit for a portfolio, the VIX does exhibit low (and negative) correlation with many of the major asset classes. The table below shows the correlation matrix for major asset classes over the past 750 days, a period during which the VIX had negative correlation with US stocks and real estate and no correlation with European stocks. Notice, though, that a similar diversification benefit could probably have been achieved with a combination of treasuries and bonds.

TIP

AGG

GSG

VNQ

EEM

EFA

VB

VV

Ishares Lehman Ti

TIP

Ishares Leh Agg F

AGG

0.95

Ishares Gsci Cmdt

GSG

0.90

0.78

Vanguard Sf Reit

VNQ

-0.78

-0.69

-0.69

Ishares Msci E.M.

EEM

0.56

0.68

0.52

-0.37

Ishares Msci Eafe

EFA

-0.14

0.05

-0.14

0.25

0.70

Vanguard Sm Cap E

VB

-0.54

-0.38

-0.47

0.63

0.25

0.75

Vanguard Lg Cap E

VV

-0.32

-0.12

-0.32

0.39

0.56

0.94

0.89

Cboe Volatility I

^VIX

0.78

0.81

0.60

-0.80

0.55

0.00

-0.39

-0.14

Note: this chart was generated on the AssetCorrelation website which is an excellent resource for monitoring the diversification of your own portfolio.

Until recently, the best way for individuals to gain exposure to commodities was through exchange-traded index funds such as IGE. Unfortunately, the exposure was indirect as you were essentially investing in the equity of companies that dealt in commodities. In the case of IGE, you were mostly holding the stocks of oil-companies. As of 2008, there are better commodity index funds, such as GSG (the Goldman Sachs Commodity Index) which gives you direct exposure to a broad array of commodities. Even better, GSG exhibits less correlation with almost every asset class when compared to IGE.

The full budget (and historical trends) is available online. Despite the din, not much has changed. The inexorable rise of medicare / social security continues, though. Medicare and social security represented 20% of the federal budget in 1971. Today they represent 40% and growing…

Take a careful look at the matrix for the various countries. Other than Brazil and Israel (with correlations of 0.73 and 0.35 respectively versus the S&P 500) the rest of the countries’ index funds are all tracking the S&P 500 with >0.90x correlation coefficients.

It might be that the time period is only 90 trading days (about 4 months) and this represents a time in the market which has seen a greater herd mentality than usual. Or it might be that global inflation fears do justify a simultaneous downward revision in global equity asset prices. Either way, lately it has been hard to see the benefits of international equity exposure. Even emerging markets like Turkey, Mexico and Chile have been strongly correlated recently. Inflation really is the great leveller.

There is a promising new website called Asset Correlation which shows the correlation matrix for a host of different asset classes over the past 90 trading days. I have been tracking it for a few months and it is amazing how all the asset classes exhibited far higher correlation during the recent panic. As normalcy has gradually returned to the markets it is interesting to see how the historical scenario of lower correlation between asset classes has returned. A few months ago almost all the cells in the matrix were green and correlations were hovering around 80-90% for most of the major classes. As of today, there is far lower correlation between the classes (indicated by the larger number of yellow and red cells). It will be interesting to keep an eye on this website over the next few months.

In 2006, promises and fees hit new highs. A flood of money went from institutional investors to the 2-and-20 crowd. For those innocent of this arrangement, let me explain: It’s a lopsided system whereby 2% of your principal is paid each year to the manager even if he accomplishes nothing – or, for that matter, loses you a bundle – and, additionally, 20% of your profit is paid to him if he succeeds, even if his success is due simply to a rising tide. For example, a manager who achieves a gross return of 10% in a year will keep 3.6 percentage points – two points off the top plus 20% of the residual 8 points – leaving only 6.4 percentage points for his investors. On a $3 billion fund, this 6.4% net “performance” will deliver the manager a cool $108 million. He will receive his bonanza even though an index fund might have returned 15% to investors in the same period and charged them only a token fee. […]

Its effects bring to mind the old adage: When someone with experience proposes a deal to someone with money, too often the fellow with money ends up with the experience, and the fellow with experience ends up with the money.

I have written about this broad daylight heist before but it continues to astonish me that people aren’t aghast at the inequity of the system.

The advent of Christmas is always a great time to count your blessings and review your charitable giving. I highly endorse Opportunity International. They make a significant difference in the lives of the poor by loaning them capital with the training and spiritual support that they need to lift themselves out of poverty. Opportunity is close to making their millionth loan to the poor. The average first time loan amount is $84 and the loans have an astonishing repayment rate of 98%. Best of all, it’s a gift that keeps on giving as your contributions are recycled again and again as Opportunity builds up a larger and larger base of capital to loan out.

Last year Americans in the lowest income quintile spent an average of $11,247 per person, according to the Bureau of Labor Statistics, compared with $15,843 for middle income quintiles, and $28,272 for the top quintile. The top group is spending only 2.5 times as much as the bottom group, and 1.8 times as much as the middle classes. This is not major inequality.

Tracking spending is vital because it is a better indicator of living standards than income and is a more reliable measure of our confidence in the future. Fortunately,

… a glance at per-person spending over the past 20 years shows that all groups are spending more in real terms. To humbly contradict the soon-to-be Senator Webb, everyone has grown richer over the past 20 years.

The lowest quintile is spending 14% more in 2005 than it was in 1985, the second quintile 16%, the third quintile 11%, the fourth 13%, and the top quintile is spending an additional 16%.

There’s no striking inequality there, especially since people don’t just stay in one quintile. Many have moved up to other quintiles in the 20-year time period as they get older and more experienced and marry other earners.

The Bureau of Labor Statistics data also provide a window on changes in our society. The bottom quintile is spending 120% more on audio and visual equipment and services, compared with the category of TVs and radios from 1985. The top quintile is spending only 31% more. Comcast and Netflix, take note.

Many people, after finally saving up a modest nest egg, are faced with the dilemma of what to invest it in. For those who don’t have any interest in spending the rest of their lives following stock tickers and listening to analyst conference calls, the following approach can be implemented extremely easily, is very cost effective, and should take less than 30 minutes each year to maintain.

This approach is suitable for people who a) have saved at least $5,000 and b) are aged 10-60. If you are older than 60 you should probably adopt a more conservative approach. If you have less than $5,000 you should spread your investments over fewer funds else trading fees will dampen your returns considerably.

At a high level, you allocate your investments as follows:

60% stocks

20% real estate

10% bonds

10% commodities

There’s no real magic to this. It just depends on how risky you want your portfolio to be. If you already own a house, I would probably halve the real estate section and increase the rest.

Then the allocation to stocks I break down as follows:

60% US stocks

40% International stocks

That is a good mix given the increased participation in the global economy of the rest of the world and helps guard against currency fluctuations of the dollar.

For the bond allocation, I recommend a broad-based bond index fund (a mix of long-term and short-term bonds). For real estate you can only really invest in commercial real estate (office buildings, shopping centers, apartment complexes). You then round out your portfolio with an allocation to commodities: oil and precious metals.

Putting that all together works out to the following target portfolio (with ticker symbols and fees of representative index funds in brackets):

12% Large cap US stocks [ VV, 0.07% ]

12% Medium cap US stocks [ VO, 0.13% ]

12% Small cap US stocks [ VB, 0.10% ]

12% International : Emerging market stocks [ VWO, 0.25% ]

12% International : Developed markets stocks [ EFA, 0.35% ]

20% Commercial real estate [ VNQ, 0.12% ]

10% Bonds [ AGG or VBMFX, 0.20% ]

10% Commodities [ IGE, 0.48% ]

If anyone finds a comparable fund with lower expense ratios, please leave a comment and I’ll update this list. For instance, in the emerging markets I have substituted VWO for EEM. The former has fees of 0.25% versus 0.75% for the latter. It should be possible to create a portfolio with a blended fee of 0.14% or less.

I generally prefer the exchange-traded funds as it makes it easier to keep all your investments in one place. I recommend E*Trade for a good blend of low fees, ease of use, and reasonable service. The disadvantage is that you have to pay a fee each time you trade whereas at Vanguard you can add money whenever you feel like without paying a broker fee.

Arranging the list in order of decreasing risk would give:

12% International : Emerging market stocks [ VWO ]

12% International : Developed markets stocks [ EFA ]

12% Small cap US stocks [ VB ]

12% Medium cap US stocks [ VO ]

12% Large cap US stocks [ VV ]

10% Bonds [ AGG or VBMFX ]

20% Commercial real estate [ VNQ ]

10% Commodities [ IGE ]

In the long run, the more risk you take, the higher your returns. The key term is “in the long run”. That’s why as you approach retirement you gradually make your portfolio less risky and weight it more and more towards bonds and fixed income securities. There is plenty of evidence that asset allocation is far more important in determining your eventual return than picking the exact stocks or countries to invest in.

The Barclays iShares web site (www.ishares.com) is the best thing since sliced bread and has pretty much everything you need to get started. Most of the funds are index funds which can be traded through an online brokerage like E*Trade.

Always try to find the funds with the lowest fees. High management fees are a vastly underestimated destroyer of long term wealth. You will always pay higher fees for international stocks and the more esoteric funds. You should definitely never pay more than 0.50% in annual fees. The highest fees are for emerging markets funds and specialty funds which should be around 0.45%. The lowest cost funds, like standard S&P 500 index funds, have fees below 0.1%. Fees tend to come down in the long run so keep reevaluating your choices. Always read the entire prospectus for any funds that you invest in so that you know what you actually own.

One slightly tricky part is balancing your asset allocation across your retirement/non-retirement/tax-deferred accounts. Thanks to the complexities of the US tax code there is no way around having three or four investment accounts. A good rule of thumb is to have the investments which pay dividends in the tax-sheltered accounts and the high-risk, high growth assets in the taxable accounts.

Finally, once you have got your asset allocation set up, you need to rebalance it once or twice a year. Since the various funds grow at different rates, eventually your carefully assigned percentages will be all out of whack. One solution is to add your latest contributions to whichever fund is the furthest off at the time. That way you end up investing new money in the funds which have performed poorly recently (buying low). At the beginning of each year, you can spend 30 minutes rebalancing your portfolio to make sure you remain on target. Resist the temptation to go with the latest fad sector. Investing is a long term discipline.

One last comment:

Your investing will dramatically improve if you read a few solid books that lay the theoretical groundwork for choosing where to put your hard-earned cash. I have read scores of books on investing and I would say that the ones that have most shaped my investing philosophy and have enabled me to outperform the S&P 500 for over 15 years are:

Buffet describes his investment philosophy as 80% Benjamin Graham and 20% Philip Fisher. Reminiscences is a classic that has stood the test of time because it so accurately describes the emotional traps that lay in wait for the investor.

Advanced Topic

Finally, there is an excellent website, Asset Correlation, which dynamically calculates a correlation matrix for the major asset classes. It is important to check that you are suitably diversified if you decide to tweak my recommended asset allocation.